Subject: Bonds - Basics

A bond is just an organization's IOU; i.e., a promise to repay
a sum of money at a certain interest rate and over a certain period of
time. In other words, a bond is a debt instrument. Other common terms
for these debt instruments are notes and debentures. Most bonds pay a
fixed rate of interest (variable rate bonds are slowly coming into
more use though) for a fixed period of time.

Why do organizations issue bonds? Let's say a corporation needs to
build a new office building, or needs to purchase manufacturing
equipment, or needs to purchase aircraft. Or maybe a city government
needs to construct a new school, repair streets, or renovate the
sewers. Whatever the need, a large sum of money will be needed to get
the job done.

One way is to arrange for banks or others to lend the money. But a
generally less expensive way is to issue (sell) bonds. The
organization will agree to pay some interest rate on the bonds and
further agree to redeem the bonds (i.e., buy them back) at some time
in the future (the redemption date).

Corporate bonds are issued by companies of all sizes. Bondholders are
not owners of the corporation. But if the company gets in financial
trouble and needs to dissolve, bondholders must be paid off in full
before stockholders get anything. If the corporation defaults on any
bond payment, any bondholder can go into bankruptcy court and request
the corporation be placed in bankruptcy.

Municipal bonds are issued by cities, states, and other local agencies
and may or may not be as safe as corporate bonds. Some municipal
bonds are backed by the taxing authority of the state or town, while
others rely on earning income to pay the bond interest and principal.
Municipal bonds are not taxable by the federal government (some might
be subject to AMT) and so don't have to pay as much interest as
equivalent corporate bonds.

U.S. Bonds are issued by the Treasury Department and other government
agencies and are considered to be safer than corporate bonds, so they
pay less interest than similar term corporate bonds. Treasury bonds
are not taxable by the state and some states do not tax bonds of other
government agencies. Shorter term Treasury bonds are called notes and
much shorter term bonds (a year or less) are called bills, and these
have different minimum purchase amounts (see the article elsewhere in
this FAQ for more details about US Treasury instruments.)

In the U.S., corporate bonds are often issued in units of $1,000.
When municipalities issue bonds, they are usually in units of $5,000.
Interest payments are usually made every 6 months.

A bond with a maturity of less than two years is generally considered
a short-term instrument (also known as a short-term note).
A medium-term note is a bond with a maturity between two and ten
years. And of course, a long-term note would be one with a maturity
longer than ten years.

The price of a bond is a function of prevailing interest rates.
As rates go up, the price of the bond goes down, because that
particular bond becomes less attractive (i.e., pays less interest)
when compared to current offerings. As rates go down, the price of the
bond goes up, because that particular bond becomes more attractive
(i.e., pays more interest) when compared to current offerings. The
price also fluctuates in response to the risk perceived for the debt
of the particular organization. For example, if a company is in
bankruptcy, the price of that company's bonds will be low because
there may be considerable doubt that the company will ever be able to
redeem the bonds. When you buy a bond, you may pay a premium. In
other words, you may pay more than the face value (also called the
"par" value). For example, a bond with a face value of $1,000 might
sell for $1050, meaning at a $50 premium. Or, depending on the
markets and such, you might buy a bond for less than face value, which
means you bought it at a discount.

On the redemption date, bonds are usually redeemed at "par", meaning
the company pays back exactly the face value of the bond. Most bonds
also allow the bond issuer to redeem the bonds at any time before the
redemption date, usually at par but sometimes at a higher price. This
is known as "calling" the bonds and frequently happens when interest
rates fall, because the company can sell new bonds at a lower interest
rate (also called the "coupon") and pay off the older, more expensive
bonds with the proceeds of the new sale. By doing so the company may
be able to lower their cost of funds considerably.

A bearer bond is a bond with no owner information upon it;
presumably the bearer is the owner. As you might guess, they're
almost as liquid and transferable as cash. Bearer bonds were made
illegal in the U.S. in 1982, so they are not especially common any
more. Bearer bonds included coupons which were used by the
bondholder to receive the interest due on the bond; this is why you
will frequently read about the "coupon" of a bond (meaning the
interest rate paid).

Another type of bond is a convertible bond. This security can
be converted into shares of the company that issues the bond if the
bondholder chooses. Of course, the conversion price is usually chosen
so as to make the conversion interesting only if the stock has a
pretty good rise. In other words, when the bond is issued, the
conversion price is set at about a 15--30% premium to the price of
the stock when the bond was issued. There are many terms that you
need to understand to talk about convertible bonds. The bond value is
an estimate of the price of the bond (i.e., based on the interest rate
paid) if there were no conversion option. The conversion premium is
calculated as ((price - parity) / parity) where parity is just the
price of the shares into which the bond can be converted. Just one
more - the conversion ratio specifies how many shares the bond can be
converted into. For example, a $1,000 bond with a conversion price of
$50 would have a conversion ratio of 20.

Who buys bonds? Many individuals buy bonds. Banks buy bonds. Money
market funds often need short term cash equivalents, so they buy bonds
expiring in a short time. People who are very adverse to risk might
buy US Treasuries, as they are the standard for safeness. Foreign
governments whose own economy is very shaky often buy Treasuries.

In general, bonds pay a bit more interest than federally insured
instruments such as CDs because the bond buyer is taking on more risk
as compared to buying a CD. Many rating services (Moody's is probably
the largest) help bond buyers assess the riskiness of any bond issue
by rating them. See the FAQ article on
bond
ratings for more information.

Listed below are some additional resources for information about bonds.